Posted by: Aaron Pressman on September 26, 2007

For years and years, one of the most reliable ways for hedge fund managers to make money was to play in the convertible securities market. Converts are similar to a bond combined with a call option on a stock, an option that the market often mis-priced. A simple strategy of buying a convert and shorting the underlying stock in essence sold the option from out of the bond. Money poured into convertible arbitrage hedge funds but by 2004 years of consistent double-digit returns came to an end. The Barclays Convertible Arbitrage Index rose just 1% that year and lost 3% in 2005. Investors moved their money out of the sector and fund returns bounced back, gaining 12% in 2006.

It’s an old, old story and one that’s oft-recurring in the history of finance. Whenever too much money is chasing the same opportunities, eventually the markets crack and the opportunity is wiped out. The heart of the efficient market theory says that such will be the fate of almost any arbitrage opportunity. And it’s this age-old explanation that may reveal what happened to the hottest hedge funds of the past few years, the quants, who saw years of cushy returns go down the drain last month.

The theory that too much money was chasing opportunities in quant funds has already been making the rounds. MIT professor and hedge fund expert Andrew Lo provides convincing new circumstantial evidence in a paper he’s written with Amir Khandani, one of his graduate students, that the boom in quant funds planted the seeds of their own semi-demise last month. Quant funds ballooned to $160 billion earlier this year from about $20 billion 10 years ago, Lo notes.

All of the funds look for a variety of small anomalies that crop up thousands of times a day in the stock market. And most look for pairs of stocks that are likely, based on past history, to move in opposite directions. The fund buys one of the pair and sells short the other, so the market’s overall direction is theoretically irrelevant. By placing thousands of similar pair trades at a time, the funds try to minimize the risk that specific news about a particular company will overwhelm the expected statistical relationship.

To figure out why such a reliable strategy broke down, the professor created a simplified version of the basic quant trade. Looking across almost all U.S. stocks, the simplified quant pairs trading strategy started breaking down long before this summer, Lo discovered. After averaging gains of more than 1% a day in the mid and late 90s, quant-based pairs trading suffered from steadily diminishing returns. By this year, Lo’s model showed the strategy gaining less than 0.2% a day. Fund managers may have covered up some of the decline by taking on more leverage, he believes. So heading into the month of August, quant funds were likely chasing weaker and weaker opportunities and taking more and more risk to do so.

Then in the second week of August, the model strategy suddenly came completely unglued. From August 7 to August 9, the model pairs trade lost almost 7%, or about 12 times its average daily change from last year. Lo doesn’t know what caused the huge drop, but speculates that it could result from a single large fund hurriedly unwinding its positions.

Lo draws several conclusions, including the recommendation that regulators focus less on forcing hedge funds to register with the government and more on analyzing the implications of major fund disasters, much as the Transportation safety Board studies individual plane crashes to find potential weakness in the entire air travel system. “By establishing a dedicated and experienced team of forensic accountants, lawyers, and financial engineers to monitor various aspects of systemic risk in the financial sector, and by studying every financial blow-up and developing guidelines for improving our methods and models, a Capital Markets Safety Board may be a more direct way to deal with the systemic risks of the hedge-fund industry than registration” Lo and Khandani conclude.

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Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money.
Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.